A reality check for Couch Potatoes

It’s easy to love index investing when equity markets are soaring. They key is to love the strategy when markets are down.

  1

by

Online only.

  1

The investment industry never misses an opportunity to take credit for outstanding performance. In fact, many mutual fund providers crow about their returns even when they’re mediocre or downright bad compared to appropriate benchmarks. One of my recent favorites was an ad that read: “Over the 1-year period, 91% of Trimark global equity funds returned 10% or more.” This is touted as an impressive accomplishment, but during this one-year period (ending September 30, 2013), the MSCI World Index was up over 21%. An actively managed global equity fund that returned even 15% would have been an absolute dog.

The recent performance of my model portfolios has been excellent: in 2013, the humble Global Couch Potato returned more than 15%, and over the last five years, a balanced index portfolio could easily have achieved 10% annualized returns. But if you’re a passive investor, it’s important to understand this performance simply reflects that we’ve enjoyed a five-year bull market in stocks—not to mention five years of bond returns that were higher than most people expected. Unlike the proud fund managers at Trimark, indexers shouldn’t take credit personally—except to pat themselves on the back for building a diversified portfolio and staying invested.

That’s why I’m uneasy when I receive e-mails from readers who tell me how pleased they are with the results of Couch Potato portfolios they’ve built in the last couple of years. Obviously I’m happy to hear from folks who have embraced indexing, but I worry their expectations may be unrealistic if they believe recent performance is typical. It’s hard not to love indexing when equity markets are soaring to new heights: it’s much harder to maintain confidence during a brutal bear market. And it’s been a while since we’ve seen one of those.

One reader, for example, recently wrote to tell me he adopted the Global Couch Potato in 2011, and since then “returns have consistently been very good compared to the money market funds and GICs I had invested in up to that time.” That’s certainly true: the Global Couch Potato has had just three negative months since October 2011. But this is highly unusual: balanced portfolios are historically much more volatile than that. Investors accustomed to high returns and low volatility are likely to be blindsided by the next correction. Unless they understand what to expect from an index fund portfolio (hint: it will plunge along with the markets) they’re likely to give up on the strategy at precisely the wrong time, declaring it “doesn’t work anymore.”

The view from the other side

Back in the summer of 2010, I heard from investors who had a completely different story to tell. One shared a story about building a Couch Potato portfolio in early 2007: some three years later, her returns were negative. Not surprisingly, she regretted her decision and wondered if the strategy was broken. It wasn’t, obviously. She just happened to have the bad luck of building her portfolio near the peak of a bull market, only to get run over by the global financial crisis that followed a year-and-a-half later.

Had this investor rebalanced and stuck with her strategy, she would have seen her portfolio recover dramatically during the next three-and-a-half years. But I would not be surprised if she bailed out in frustration, because her expectations were unrealistic. “I had read that gains were steady with the Couch Potato strategy,” she wrote, “but do not see that with my portfolio.”

So let’s be clear: if you’re investing in a portfolio of stocks and bonds, your gains will never be consistent or “steady” for very long. On the contrary, you’ll suffer through a series of dreadful, gut-wrenching months alternating with exciting, hard-charging bull markets. There will be periods when indexing feels like the greatest investment strategy ever devised, and others when your emotional brain is telling you only a moron would do such a thing. You need to be prepared to endure the latter, or you won’t be around to enjoy the former.

Building a low-cost, broadly diversified portfolio is the right thing to do. Just make sure you’re not doing the right thing for the wrong reasons.

One comment on “A reality check for Couch Potatoes

  1. I built my first couch potato portfolio with the legacy trust my Mom left my then mid -teenaged son in her will – in February 2008! Needless to say it was a very hard couple of years to start, and I struggled to keep my hand off the sell all button in my online investment account. I ended up with a -20%+/- result the first year. But, I have stuck with it, and followed the rebalancing process for over 6 years now.

    We took out a small amount of capital for special purchases. This was a legacy to be used for ‘educational purposes’ with me as the trustee until he turns 25. He got a new laptop, and he went on an expensive school trip to Japan in Grade 12. He will be 21 this year and in 2nd year at university. We have taken out the income each year, as he has been able to utilize it for some special purchases, and this year, when he moves away from home he will start to draw enough income/capital to pay his rent while he continues with his studies. There is more than enough to keep him going, and have something left when he gets control over the remainder.

    I have maintained an average 5.08% rate of return before tax (which he doesn’t pay as a student) with a mix of laddered GICs, and EFTs, including the starting year of 2008/09.

    I just kept reminding myself that we didn’t need the money then – we had an RESP too and they were already moved to a GIC ladder and would be available when he first finished high school. We had time to let the market correct and return, and I knew it would – oh, did i forget to tell you that I had retired from the mutual fund industry in 2007 to give my Mom palliative care? With 25 years of professional experience in the industry – I knew I could hold tight and keep our son’s legacy working for him. The thing was, that I couldn’t work with EFTs in my job, but I was determined to get into them on a personal basis, and am so glad I did.

    I now have our RRSPs/TFSAs 100% in a Couch Potato Strategy, and our emergency cash holdings with laddered GICs. I don’t work in the financial services marketplace anymore, but I have to say, my comfort with investing has been good since I made the switch from mutual funds, including the challenges of good/bad market conditions. I love the ease of it all, and know that I can hang tough for retirement now. I am not worried about the pending downturn – I have some new cash waiting to be invested from my Dad’s estate and this trend will work just fine for me.

    Reply

Leave a comment

Your email address will not be published. Required fields are marked *